Frank Armstrong III
JANUARY 2007 - Are
traditional pension plans an endangered species? Defined
benefit (DB) pension plans create high costs and risks that
have contributed to some spectacular bankruptcies, such
as United Airlines, which terminated its pension in 2005.
General Motors was also in the news when its pension fund
reached shocking debt levels last year.
to the Pension Benefits Council, in 1980, 38% of Americans
had a DB pension as their primary retirement plan. By 1997
it was down to 21%, and this number has likely fallen further
in the last several years. In addition, an increasing number
of underfunded plans have been taken over by the Pension
Board Guarantee Corporation (PBGC), a federal government–chartered
agency that insures pensions.
a defined contribution plan, a defined benefit has some
or all of its benefits guaranteed. If a DB plan is underfunded—meaning
that there is not enough money available to satisfy all
the covered benefits—then the PBGC must step in. Accordingly,
the termination of a defined benefit plan is much more complex
than the termination of a defined contribution plan.
an employer freezes an existing DB plan, the plan continues,
but employees accrue no further benefits. The company may
need to make further contributions if the plan is underfunded
the company terminates the plan, either the accrued benefits,
including all unvested benefits, must be paid out as a lump-sum
equivalent, or the plan must purchase a annuity from an
insurance company. It goes without saying that the plan
must be fully funded when terminated.
a company freezing or terminating a DB plan will then start
some form of defined contribution plan to take its place.
It is unlikely that the benefits of the two plans will be
equivalent. DB plans tend to favor older, long-term employees.
These employees may be worse off, while younger employees
may find that they potentially have higher projected benefits.
a plan will be converted into another form of DB plan with
entirely different sets of benefits. In a famous recent
case, older IBM employees successfully argued that the conversion
to a cash-balance pension was blatantly discriminatory because
the new formula actually reduced benefits with each additional
year of service.
or Involuntary Terminations
companies fail outright, taking their DB plans down with
them. The Employee Retirement Income Security Act (ERISA)
established the PBGC to provide employees with at least
partial insurance of their accrued benefits in DB plans.
Today, almost a million present and future retirees look
to the PBGC for their retirement benefits.
employer plans pay an annual per-participant fee of $19
as well as 0.9% of any amount the plan is found to be underfunded.
The premium is mandated by federal law, and to date has
not been sufficient to cover existing liabilities. Even
though the PBGC itself is insolvent, Congress has been reluctant
to raise the premiums, perhaps fearing that it might accelerate
the trend away from DB plans. The recently passed Pension
Protection Act of 2006 includes provisions designed to strengthen
DB plans, but its longer-term effects remain to be seen.
a plan does not have sufficient assets to pay all its intended
benefits and the employer is in such distress that continuing
the plan might cause the company to fail, it can petition
the PBGC for a distress termination. In a distress termination,
the PBGC steps in to pay “guaranteed” benefits
and attempts to recover the balance from the employer, either
over time or in bankruptcy.
the PBGC find that it is in the best interest of the employees,
the plan, or the PBGC itself, they can take over a plan
without the employer’s consent. Finally, if a firm
suspends operation or cannot continue as a going concern,
the PBGC will take over the plan.
Road to Insolvency
stock market decline of 2000–2002 devastated many
DB pension plans. Much of this grief was self-induced and
the many factors that go into determining annual pension
expense, none is more critical than the plan’s rate-of-return
assumption. If the plan assumes a high rate of return, then
the annual cost estimate is reduced. This is very tempting.
If a company can lower pension costs, the savings go right
to the bottom line. But hoping for higher returns doesn’t
make it so. If those returns fail to materialize, the plan
will soon be underfunded, and the annual costs will rise
again to reflect the additional deposits required to fully
fund the plan.
only way to ensure that a DB plan will not be underfunded
is to buy long-term bonds that mature as needed to fund
plan commitments; in other words, match assets with future
liabilities. But this implies a very low rate of return
and high annual costs. So most DB plans invest in a mixture
of stocks and bonds to increase the rate of return. The
more volatile the assets, the higher the assumed return,
and the higher the risk.
the late 1980s and the 1990s, many plan fiduciaries increased
their rate-of-return assumptions to reduce estimated annual
costs. Lulled by long market advances, actuaries, the Labor
Department, employees, and labor unions all bought into
the decision. Plans took higher levels of risk to attempt
to meet their rate-of-return assumptions and did not properly
diversify their portfolios. When the market tanked, some
companies found that their DB plans were suddenly underwater
at just the time that their business was in distress.
Pensions Hard Hit
enacted in July 2004 relaxed funding standards across the
board and specifically allowed two distressed industries,
airlines and steel, temporary additional underfunding. If
this legislation represented a massive bet for the government,
then the Pension Protection Act of 2006 could be seen as
doubling down on this bet. The new law generally requires
plans to reach full funding over a seven-year transition
period, with longer periods specifically allowed for airlines.
If the funding levels do not recover over time, the PBGC
will be forced to take on plans that have become even more
severely underfunded. With the PBGC itself already severely
in the red, the prospect of allowing any employers to further
underfund their plans may come back to bite the agency with
legislation was driven by the fact that the airline and
steel industries, already financially weak, were particularly
hard hit in the wake of the terrorist attacks of September
11, 2001. United Airlines terminated all its DB plans, dumping
an additional 120,000 employees into the system with a projected
cost to PBGC of over $5 billion. This follows the distress
termination of the US Air’s pilots’ pension
plan. As one airline after another dumps pension plans on
the PBGC, the temptation for the remainder increases. The
industry is highly competitive, lacks pricing power, and
suffers from overcapacity; established airlines are being
undercut by start-up ventures with lower operating costs.
Cutting costs by dumping pensions may be the only way some
carriers can survive. Unfortunately, the U.S. taxpayer may
end up paying the bill.
on Plan Participants
employees may be fully covered, but highly compensated employees
will find that the PBGC guarantee covers only a small portion
of their benefits. They can be financially devastated by
a plan termination. While plans can fund to a maximum of
$165,000 per year at normal retirement, the PBGC maximum
guaranteed benefit for plans that terminated in 2004 was
plans sponsored by distressed companies offer a lump-sum
benefit, the threat of possible plan termination can cause
a “run on the bank,” where senior employees
attempt to secure their lump sum prior to the termination.
For example, Delta Airlines had 300 pilots retire in June
2004 alone, 266 of them early. Unfortunately, every employee
who succeeds in securing a lump-sum payment further weakens
the fund for remaining participants. This downward spiral
increases the probability that the plan will find itself
in a distress termination.
if companies maintain multiple DB plans for different employee
groups, they may have the option to pick and choose which
plans to terminate. For example, US Air, operating under
Chapter 11 bankruptcy, was allowed a distress termination
of its pilots’ pension plan while continuing other
employees’ pensions. Senior pilots found their benefits
cut by over $100,000 per year. That represents a roughly
$2 million decrease in assets that had accrued over a 30-year
career for each pilot.
PBGC’s process is often arbitrary and capricious.
When challenged, it has proved to be a tireless litigator.
For example, when the PBGC took over the pilots’ pension
plan at Eastern Airlines, it was almost fully funded, while
other groups were greatly underfunded. The pilots had, through
the collective bargaining process, negotiated for increased
funding for their plan, which was paid for by reducing their
pay. Nevertheless, the PBGC promptly transferred the pilots’
funds to less fully funded Eastern employees’ plans.
This shortchanged the pilots’ plan, but reduced the
PBGC’s liability for the other plans. This “theft”
was never challenged in court. When Pan American Airlines
folded, its pilots’ pension plan was underfunded.
During the administrative process the stock market rebounded,
greatly enhancing funding levels. The PBGC kept the additional
funds and successfully argued in court that it was not the
fiduciary of the plan, but its insurer. The pilots received
minimum benefits rather than the benefits the plan could
have provided with the enhanced asset values.
trend away from the traditional DB plan is probably irreversible,
as companies increasingly attempt to reduce costs and avoid
possible future liabilities for underfunding. Employees
currently covered under DB plans must consider that their
anticipated benefits may be reduced in the future. This
is particularly of concern in distressed industries where
highly compensated employees could experience significant
benefit cuts. As in almost all other aspects of DB pension
plans, employees are along for the ride, with little or
no control over their plans.
Armstrong III, CFP(r), AIF(r), is the founder and
principal of Investor Solutions, Inc., a fee-only registered